My Company

Only time will tell how the courts will respond to the public policy issue after recent cases. However, properly structured defined value clauses should work.

Gifts or intra-family sales of hard-to-value assets (such as interests in closely-held entities) can result (upon an IRS audit) in unexpected gift or generation-skipping taxes. Generally, planners have used two types of formula clauses to avoid unintended gifts when gifting or selling hard-to-value assets. A price adjustment clause automatically adjusts the amount transferred if the IRS successfully challenges the value on a gift tax audit (a “condition subsequent”).

In such event, the transfer instrument undoes a portion of the gift and either returns the excess to the donor (in the case of a gift) or increases the consideration paid to the transferor (in the case of a sale). However, price adjustment clauses are not viable because they violate public policy by discouraging audits (since enforcement simply defeats the gift). Commissioner v Procter, 142 F.2d 824 (4th Cir. 1944), cert denied, 323 U.S. 756 (1944); Rev. Rul. 86-41, 1986-1 C.B. 300.

In comparison, a defined value clause defines the amount transferred from the outset (i.e., a condition precedent).

For example, with a defined value clause, the donor transfers a specific dollar amount to the donee instead of a percentage interest in the asset (i.e., “I transfer to Trust 'A' so much of my XYZ stock that has a fair market value of $5 million”). If the IRS assigns a higher value than the one reported on the donor’s gift tax return, the excess passes to a nontaxable beneficiary such as the donor’s spouse, a charitable organization, or a zeroed-out GRAT (i.e., “To the extent the value of the XYZ stock exceeds $5 million, the trust shall transfer the excess to the ABC charity”).

McCord v. Commissioner, 120 T.C. 358 (2003), rev’d, 461 F.3d 614 (5th Cir. 2006), involved a formula with the excess (the gift over) going to specified charities. Although the tax court refused to give effect to the defined value clause, a majority of the tax court would have respected the defined value clause if it had provided that the amounts allocated to each donee were to be determined using the “fair market value of the gifted interest as finally determined for Federal gift tax purposes.”

On August 22, 2006, the Fifth Circuit Court of Appeals, in a unanimous decision and without any discussion of Procter and its progeny, reversed the tax court’s decision and upheld the defined value gift formula used by the taxpayer in McCord.
In Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008),aff’d, 586 F.3d 1061 (8th Cir. 2009), the tax court approved a formula disclaimer clause that operated much in the same manner as a defined value clause. In so holding, the tax court rejected the IRS’s consistent position (as reflected in Procter) that such clauses discourage the IRS from litigating valuation cases and, therefore, are invalid as against public policy.

In Christiansen, the decedent’s daughter made a formula disclaimer of everything in the estate (which included hard-to-value assets) in excess of $6.35 million. Any excess passed to charity.

Christiansen is important because a unanimous tax court held that the disclaimer was effective to pass to charity any increase in the federal estate tax valuation of the estate, and that the formula clause did not violate public policy. By contrast, the Fifth Circuit in McCord did not specifically address the public policy issue raised in Procter. On November 13, 2009, the Eighth Circuit Court of Appeals affirmed the Tax Court's decision in Christiansen. Estate of Christiansen v Commr., 104 AFTR 2d 2009-7352 (8th Cir. 2009).

In Petter, the tax court discusses four reasons that the defined value clause used in that case did not violate public policy: (1) there is a general public policy encouraging charitable gifts (the gift over in Petter passed to charity); (2) there are other potential sources of enforcement of the gift and sale transactions other than gift tax audits (i.e., the fiduciary duty of the charities to assure they receive what they are entitled to); (3) the mootness and declaratory judgment concerns mentioned in Procter are not appropriate; and (4) the existence of other formula clauses authorized in regulations (such as marital deduction formula clauses) suggest there is no general public policy against lifetime transfers by formula clauses.

The most recent defined value case is Hendrix v. Commissioner, T.C. Memo 2011-133 (6/15/2011) where the taxpayers used a defined value clause which allowed them to transfer shares in a closely-held corporation (with a certain value) to trusts for their descendants, with any excess passing to a charitable foundation. After the transfer, the trusts and the foundation independently determined how to divide the total shares transferred according to the defined value formula clause.

Since the foundation was represented by independent counsel and had a fiduciary duty to make sure it received the proper number of shares under the formula clause, the tax court held that the defined value formula clause should be respected for federal tax purposes as the result of bona fide arm's length negotiations.
It’s not certain that the court’s reasoning in Christiansen, Petter and Hendrix will cover defined value clauses where the excess gift or bequest does not pass to charity. The tax court in Christiansen was not overly concerned that taxpayers will "lowball" the value of the estate to cheat charities because “executors and administrators of estates are fiduciaries, and owe a duty to settle and distribute an estate according to the terms of the will. … Directors of foundations … are also fiduciaries … [and] … the state attorney general has authority to enforce these fiduciary duties … .” 130 T.C. at 17.

Outside the context of charitable bequests, such enforcement may be lacking. But whenever the gift over recipient of the excess value under a defined value clause is a trust, the references to fiduciary duties would seem to apply.

Where the gift over will not pass to a charity, then most planners have the gift over pass to a trust (where the donor retains a limited power of appointment so that the gift is incomplete), to a spouse or lifetime QTIP trust for a spouse (so that, in either case, the gift over qualifies for the unlimited gift tax marital deduction), or to a zeroed-out GRAT.

To assure compliance with the trustee's fiduciary duty (to receive the correct amount of the gift over), an independent trustee should be used. In addition, in those situations where the gift over is not going to charity, it may be advisable to use a defined value clause that generates a small (1 percent to 2 percent) gift tax. This will assist in avoiding the public policy argument that a contest by the IRS would be moot because the defined value clause takes away any gift tax consequences.

Only time will tell how the courts will respond to the public policy issue after Christiansen, Petter and Hendrix. However, properly structured defined value clauses should work. It is hoped that the IRS will eventually provide some guidance on them.

TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS IT IS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.

About the Author

Julius H. Giarmarco, Esq. is a partner and heads up the firm's Trusts and Estates Practice Group. Julius received his law degree (J.D.) from Wayne State University, and his master of laws (LL.M.) from New York University. His primary practice areas include estate planning, business succession pla... More